Economics

Monetary policy

The Eager for Catastrophe Bank

IT IS safe to say that we have passed the point at which criticisms of the European Central Bank must be prefaced with the caveat that, yes, the ECB did prevent a nasty break-up of the single currency when its head, Mario Draghi, promised to do "whatever it takes" to keep the euro zone together. At this point, that decision is looking less like heroism than sadism, a bit like saving a trauma patient's life only to subsequently starve him to death. ECB policy can at this point be described as both cruel and unusual.

The latest evidence is damning. The euro-zone unemployment rate hit a new high in January at 11.9%. Unemployment rates touched dizzying new levels around the periphery; Greece, with unemployment at 27% as of November, is in the lead. Just as worrying are rate rises in much of the core. French unemployment continued to inch up and now stands at 10.6%. But unemployment has also increased by roughly a percentage point over the past year in both the Netherlands and Austria. The ranks of those spared by rising joblessness continue to shrink and retreat northwards.

One might normally explain these figures away as the actions of a central bank dangerously obsessed with inflation. And indeed, the ECB seemed proud of the fact that year-on-year inflation dropped to 2.0% in January. But this is an unsatisfactory story. As the chart below shows, prices have been falling sharply of late. For the euro zone to maintain an inflation rate near 2% over the coming year would eventually require a return to inflation well above the 2% target. (A flash estimate of year-on-year inflation as of February put the rate down to 1.8%.) If ECB policy is this naive, aiming to keep year-on-year inflation at 2% while entirely ignoring recent inflation trends, then it quite simply doesn't deserve to be entrusted with euro-area monetary policy.

But the ECB isn't that stupid. Instead, it appears to want to avoid making life too easy for the reform-sceptical governments around the periphery. A decent macroeconomic environment might lead governments to relax plans for reform and could even lead to budget improvements without painful budget cuts. But peripheral voters are calling the ECB's bluff and it has only itself to blame. Deprived of reasonable macroeconomic management, they have little reason to accept further policy diktats from the ECB and the European Commission.

So what will the ECB do now? It can either turn the screws some more in hopes of getting its way, possibly hastening the euro zone's demise amid macroeconomic ruin. Or it can do what central banks are supposed to do and prevent a demand-side disaster. Meanwhile, many Europeans must be questioning whether they really and truly want to yoke themselves to such an especially cruel bank.

Readers' comments

Indeed the American solution: printing money and create an ever greater debt cannot be the answer. When you play you have to pay. All governments played and now it is pay time. I cannot make debts and just not pay them, the bank would take my assets. This is the kind of economy we have and this goes also for nation states. The problem is that career politicians are usually not fit to work in the real economy and therefore are prone to dole out benefits to be reelected as there is no repercussion if they debts they create is not covered. They have their plush pensions which are covered by even more debts and cheques drawn on the future. Stop the spending of money that is not available as every household should be doing.The US is definitely not the blue print. They'd like us to do the same stupidity in Europe as it takes away the pressure on themselves and they do not like the Euro as it means competition for the $.

I find myself very often in support of Free Exchange, mostly RA (or is it RC? memory is no longer accurate for details).
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Scarcely so this time.
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I insist the World is repeating since 2002 the late twenties and thirties. We all remember the big crash of 29, the big Debt and Banking crises, the Great Depression and finally WW2. It looks as if frighteningly following exactly the same path.
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What we forget is small details I lived through as a child.
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In the early 30's after the big crash and the big Bank debacle as the Great Depression was beginning to straddle over the whole world, two small countries imposed austerity to cure debt and in fact or de jure reformed their currency: Portugal and Switzerland.
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One by means of a rather mild dictatorship(in comparison with the others in Europe), the other with her perennial democracy. Well, a little watered down: on the other side of its German speaking border there be Nazis.
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Some twenty years later, in 49, only three countries were better off than in 29: Portugal, Switzerland, Sweden.
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All right, all right: none had seen war destruction. But neither had the USA Canada, New Zealand (Australia had Darwin bombed) Spain nor Turkey.
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As yet we know preciously little about economics: we are to Economics as we were to Astronomy after Galileo. We know the Earth circles the Sun, not vice versa (markets are more efficient than planned economies) but the Kepler of economy who will draw the movement equations has not been born yet.
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So, despite Der Perfesser whose great knowledge and great efforts have not yet persuaded me, we have to rely on analogies.
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Similar causes produce similar results.
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Austerity is a very painful remedy. But it is the only one we know that cures debt.
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Ah! wasn't Sweden an exception?: not quite, she made a lot of money from exports to Germany of natural resources very scarce in Portugal and Switzerland and besides, although not so fierce, she also followed a policy of austerity.
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In a few decades we may find there are better solutions to debt hangovers than austerity.
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For the time being it is the only efficient and reliable solution we know.

So the alternative proposed by the author is taking on massive debts just like in the US? The US culture seem to be based on rewarding those who are responsible for the mess and punish those who have nothing to do with it. Spending the money today in order to shelter those who made a mess out of it and who are dead and gone when the bills must be paid should be considered cruel. Americans do not seem to care about anything else than today and about themselves; it doesn't mater if it is about the environment or about debts, they must really hate their children.

Cry us a river, why don't ya'?
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What would you have the ECB do - hmmm? They're not permitted to buy government bonds except as part of rate-aid to states in approved programs - of which there are presently none. Want them to start buying up corporates? Where do you find the statutory authority for that? And about this -
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"If ECB policy is this naive, ... then it quite simply doesn't deserve to be entrusted with euro-area monetary policy."
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It isn't entrusted with making monetary policy in the sense of choosing growth over low inflation - that policy is set in stone in the ECB's organic legislation. The bank has no legal authority to manufacture inflation at any rate, even 2% - under any circumstances. If that mandate is to be changed, it isn't the bank itself that gets to re-write it. Until it is modified, the Bank just has to 'keep on keepin' on' - probably best to do that anyway.

At this point, that decision is looking less like heroism than sadism,
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You and M.S. (Democracy in America) have GOT to stop hanging out together, drinking after hours at the bar.
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BTW... what's the name of that bar?
(nudge, nudge, wink, wink)
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NPWFTL
Regards

Rodny is right. YOu want a medical analogy? The US under Bernanke is like an obese overweighed patient who almost died of heart atack but was saved in extremis by massive dose of dope. No real cure but the same prescription to gorge on more debt by the witch doctors. "cruel" ECB ? LOL.. the West has no backnone, ECB is 100% correct with austerity, you got to break the cycle of debt at all cost, put the finances in order and rates will tumble. Absolutely no balank cheque. Cut the crocodile tears would you. Those who sinned just need to pay the price, they not gonna die believe me, I have seen history and other countries in Asia go through even tougher conditions and come out healthier. Cheers for the ECB and Germany for keeping sanity in a craze world as represented by the US !

If we adopted the approach implied by this article it is probable that no one would ever really engage fiscal restraint. If money is printed or deficits are increased in order to provide artificial demand, where is the incentive for anyone ever to change their behaviour ? Consider how large the deficits and debt would become.

The fundamental issue is solvency and this cannot be cured by running perpetual deficits in the hope that growth re-emerges from an uncompetitive and unreformed economy.

The implication within the article is that we should keep distributing insolvency by continuing to increase the quantity of money faster than the growth of GDP. This will only serve to destroy the remaining areas of solvency in nation states which would become increasingly insolvent.

It is quite logical that economic growth must be impaired due to reduced demand which itself is reduced because of the withdrawal of credit and the spontaneous curtailment of consumer debt. Essentially this is good because the false economic bubble in which we have all been living is now being deflated. We must all now learn to live within our means and governments should move to operate within a balanced budget as Germany has done.

The consequence will obviously be transitional higher unemployment but this should be seen as an indicator of progress toward a smaller state, a larger private sector and sustainable national accounts.

As long as the bubble remains inflated there can be no real progress toward solvency.

Article truly poor of arguments and recipes: "things go wrong, the ECB must do something, but I do not know what".
What would be the magic wand measure that the ECB should take and does not take for its cruelty?!
1. To lower rates, in an enviroment still suffering from fragmentation, is not effective: the lowering passes on only where it is not needed, worsening the imbalances.
2. The ECB is already giving the banks all of the cash they ask for, with very loose rules for collateral. They can try another LTRO/MRO with conditions attached to induce to lend to firms and households, and it seems there is something like this in the pipeline.
3. But what makes you think that monetary policy can increase employment? It can only increase liquidity. But liquidity is not enough to induce firms to invest. Only national governments can do the structural reforms needed to make life easier for companies. This is particulary true in the italian case, for example, where business is burdened by bureaucracy and excessive taxation.

Hey, look on the bright side: this euro crisis is helping to remove the income inequality in Europe in a big way. At the present rate, it'll take only a couple more years for eastern members like Poland and the Czech Republic to catch up to the laggards in the eurozone. Romania seems to be benefiting in particular from the troubles in Latin Europe. Thanks to language similarities, many firms in Spain and Italy fed up with high taxes are transferring their lower-skill operations, like customer service, to Romania.

We should think of the present situation as the rectification of the historic wrong at Yalta. Don't like diktats from the ECB? Try the Kremlin.

I believe this post correctly identifies the critical relationship, namely that between the ECB & the voters in the countries experiencing austerity. I expect that this will play out as follows: although the majority of voters in someplace like Greece will accept austerity versus exit from the Euro, a minority will require political repression that approaches martial law to deal with violent demonstrations by the unemployed who have nothing to lose. This is how the crisis will come to a head. The ECB has no choice but to play out it's institutional hand until it is given a different mandate. The real issue is how far a democratic government can go down this road of political repression in order to impose the will of the majority on those suffering the most from these policies. The policies may even be a rational response to a difficult situation. But rationality will not be the decisive factor. I wish it would be otherwise, but this is what I expect. I'm addicted to reality & have a problem with magical thinking.

BTW, can I exhume the Philips curve and point out that even Keynesians understood that prices shouldn’t rise with inflation.
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"shouldn't rise with unemployment"?
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The ECB is a king of nothing due to no centralization.
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All the ECB can do is print money to buy bonds from banks, which are individual gov't bonds.
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Similar to if the Fed printed money to buy individual state bonds.
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Perhaps we are back to "the chicken or the egg" theories.
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Does the ECB buy the chicken - individual state bonds - or buy the egg - await centralization (a Euro Treasury) and buy Euro-bonds issued by the Euro Treasury.
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NPWFTL
Regards

A central bank that changed policy based on the data from one month would truly be foolish. The Fed makes policy on forecasts, not last month’s data and I assume the ECB does the same thing. Of course, the forecasting models aren’t that good.

Why is their inflation with rising unemployment? Rising unemployment should cause deflation. If prices should be falling instead of rising that suggests the real inflation rate is much higher than the nominal rate. Austrian economists invented the concept of real interest rates based on analysis of how an economy works with a fixed stock of money. It’s a powerful analytic tool that would improve mainstream thinking a great deal.

BTW, can I exhume the Philips curve and point out that even Keynesians understood that prices shouldn’t rise with inflation. What we have in the Big EZ is stagflation.

Each country has it's own set of taxes, rules and regs that drive up cost. Costs which are tacked on to a product or service cost.

How much time are you willing to give up in exchange for a product or service? The value of a German worker's Eurodollar is the same as Greece. That isn't going to fly long. Something is going to give.

That something is forcing other countries to improve productivity. Either cut costs or start busting ass. But something is going to move.

These charts illustrate the fallacy of the common currency in an economic union without labor mobility as is found in successful economic unions such as the US. The PIGGS, constrained by an external currency which they cannot devalue, must 'export' their surplus labor to other states. However, it is not as easy for a Greek construction laborer to move to Denmark for work as it is for a Nevada worker to move to Virginia.
There is no one correct path for the ECB given the divergence in the economic performance of the different states. So the ECB will muddle through with a largely correct policy for the dominant economies and the peripheral economies will just have to hang on as best they can until they ultimately give up.

You ought to read Phillip Bagus' "The Tragedy of the Euro." Bagus shows that Germany has a tiny minority of the seats on the ECB board. The whole point of the ECB was to reduce Germany's power in Europe.

This issue, this whining, this hand-wringing and emo-outpouring in buckets-full - it takes me back to like '81, and all the arrows Volcker was taking from all directions (except from Reagan's) when prime was double-digits and unemployment was off the charts. It's gotta be done, and when it's done it will be over.
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Deal with it.